Markets & Finance

When the Chips Are Down

June 27, 2002

By Thomas W. Smith, CFA Times have been tough for semiconductor-sector investors recently. A multi-year recovery for worldwide chip sales began in the first quarter of this year, but, since then, the group has been hitting a few bumps as demand for PCs has turned out to be weaker than expected.

The trouble started in early June, when Intel posted a mid-quarter update that lowered guidance for revenue and, more importantly, gross margin for the June quarter. Intel cited weaker than expected PC demand in Europe. However, the world's largest chipmaker remained optimistic about seeing typical seasonal strength in the second half of 2002. It has launched a major advertising campaign, perhaps to spread optimism and stem the fall in its shares. This week, Intel stock touched a new 52-week low of $17.45 before recovering to around $18.70, down from around $28 a few weeks ago.

We at S&P still think Intel's sales can run higher in the second half of 2002 than the first half, but we see the chances for strong upside surprise in PC demand as being now more limited. We rank Intel (INTC) as avoid (2 STARS), meaning we believe the shares will moderately underperform the market over the next 6 months to 12 months.

; ranked 2 STARS) may limit profits. In turn, analysts' estimates are still coming down. Over the long-haul, though, Intel will be helped by its size advantages in production, along with its outstanding research.

AMD's midquarter update was the next bomb to drop in the warnings season for PC-oriented chipmakers. AMD surprised the Street by lowering revenue guidance way below its previous range. Management talked about weak PC demand not just in Europe, but also in North America. They confirmed the notion put forth by Intel that component-buying for back-to-school computer building, which normally begins the last week of May, was weak. This implies that the back-to-school sales season might run weak, which would dampen estimates for the September quarter results.

However, it also might be just a reflection of the chip cycle. We still are in the early stages of the expansion, when lead times for fulfillment of orders is quite short. So, if a computer maker wants components from Intel or AMD, the parts are readily available within days. As the cycle runs toward its middle stage -- maybe this autumn or next year -- lead times will lengthen so that orders will have to be made weeks in advance of customers' need for delivery. There's still some possibility that back-to-school orders will be larger than expected if customers are just putting off their orders until the last minute, meaning late June and July.

; 2 STARS) on June 25. Micron said less memory was being sold per computer -- which is largely a result of high DRAM (dynamic access random memory) chip prices. But now that DRAM prices have dropped, the trend toward using more memory per box is on the rise.

Among the drivers for the use of more memory are Intel's Pentium 4 processor and Microsoft's Windows XP operating system, which work better with 256 megabit (mb) memory configurations. The 256mb chips will likely replace the 128mb standard by yearend 2002. All the same, Micron saw its total inventory rise during the May quarter, which is troubling. Still, things might work out O.K. -- if demand is strong through the summer.

Another negative for Micron is the investigation of the DRAM industry by the Justice Dept., which is likely looking into antitrust violations. Subpoenas for information went out to all the top DRAM makers, but it's unclear what investigators will find or what they will do. For now, we view the investigation as a minor factor in the Micron story.

NO DRAM DROUGHT. For Micron, the biggest problem may be industry overcapacity in DRAM. Even though many small competitors worldwide have left the segment over the past five years, and many Japanese makers have curtailed their DRAM operations, there's still plenty of supply.

Micron wanted to level the field with its plan to acquire Hynix -- the third largest DRAM producer behind Samsung and Micron. But the deal failed in May because of opposition from Hynix' unions and various political powers in South Korea. Now Hynix, which was propped up by a new arrangement with creditors after losing a lot of money in 2001, might never be sold.

With the Hynix factories still running, supply of DRAM looks ample for the time being. This contributes to low pricing for DRAM chips, causing Micron and other industry participants to face a challenging profit picture.

TWO STOCKS TO WATCH. While PC-oriented chipmakers have turned sour for the moment, investors may take heart in upbeat midquarter reports from chipmakers tareting much broader end-markets for simpler chips. This would include so-called discrete semiconductors (chips that perform a single task), power-management chips, analog chips, and microcontrollers.